Japan Fires Another Shot in Global Currency War

By MICHAEL J. CASEY
Oct 31, 2014
A currency war looms not a 1930s-style scorched-earth conflict, but a damaging
stealth war that will exacerbate the global economys woes and distort domestic political
agendas.
The Bank of Japan s surprise move to increase its asset purchases has sent the
yen plummeting, with the dollar passing through 110 Friday to trade at highs not seen
in six years. This is the mechanism through which Japan will try to restore inflation to its
perennially stagnating economy. The BOJ describes its actions in terms of
boosting domestic growth and pricing power, but the real way it works is to export
deflation to the rest of the world it has been doing this ever since the yen began an
30% decline versus the dollar once Abenomics stimulus measures were first floated in
the fall of 2012.
Despite ceding its status as the worlds second-largest economy to China, Japan still
accounts for a whopping 8% of global GDP. And it is an even more important
contributor to the worlds supply of manufactured merchandise. As a weakening
exchange rate drives down the price of its cars and electronic goods overseas, Japan
creates competitive challenges for other countries producers, putting jobs at risk and
policymakers in those places under political pressure to respond.
Those responses are already evident: in the Bank of Korea cutting rates this month
and coming under pressure in parliament for more; in the Reserve Bank of New
Zealand making uncharacteristically overt warnings about the strength of the kiwi;
in the central banks of the Czech Republic, Sweden and Israel hitting the same zero
bound limit for interest rates at which the U.S., eurozone, Japan, U.K and Switzerland
have been stuck for years.
The biggest players in the global monetary system have mostly resisted direct tit-for-tat
responses to Japans yen-weakening moves over the past two years. But its only a
matter of time before their policymakers use words or actions to combat its effect. The
upshot: even more global deflation and sluggish growth.
Consider China, which arguably has the most to lose from competition with Japan
and,even more so from a weakening South Korean won. Since the start of summer,
the Chinese yuans exchange rate, which is managed against the dollar, has risen
steadily versus the greenback while virtually every other currency has fallen. As such,
the yuan is up 12.5% against the yen since late June and 11% versus the euro.
For an economy whose manufacturing exports are its lifeblood and thats going through
a challenging slowdown, this is untenable. Riding on the dollars coattails has put
enormous pressure on China in terms of its export competitiveness, says Cornell
University and former International Monetary Fund economist Eswar Prasad. He
expects to soon see a fair amount of intervention by the Peoples Bank of China to
keep the [yuan] from rising on a trade-weighted basis. That, in turn, will induce other
Asian governments into heavy intervention, he says.
It will also play out in the fractious politics of the eurozone. Already, deflation risks have
led European Central Bank President Mario Draghi to open the door to bond
purchases, driving the euro lower. But he faces stiff opposition from the Deutsche
Bundesbanks hard-money diehards, especially over the more controversial option of
buying sovereign bonds. France, by contrast, would desperately love a monetary boost
to help it meet its EU-mandated fiscal targets. And Greece, whose bonds are now
returning to crisis prices, is dying for the same. These strugglers are on a collision
course with Germany and other healthier northern European nations as well, perhaps,
with Spain, which resents the idea of Frances freeloading on ECB support when it has
had to make painful economic adjustments. More imported Japanese and/or Chinese
deflation will merely exacerbate these tensions.
Then there are economies that are really in trouble: places like Russia, Venezuela and
Brazil, for whom a falling oil price is leaving their finances exposed even as they are
forced by stubbornly high inflation and currency outflows to hike rates rather than cut
them. In this environment, global competitive depreciation could trigger outright crises.
The wild card is the U.S. As a mostly domestically driven economy, America can bear
the pain of a stronger dollar for a while but thats not boundless. Strikingly, Federal
Reserve Vice Chairman Stanley Fischer has already voiced concern about the
depressing economic impact of a stronger dollar.
For now, the U.S. continues to grow and add jobs, but it cant be the worlds only engine
of growth indefinitely. So, while the Fed is still likely to go through with a first rate hike in
the spring or summer next year, this global game of passing the deflation hot potato will
inevitably slow or even halt the process of U.S. monetary tightening.
Thus the stealth currency war will become complete. And the world economy will be no
better for it.